Last week we talked about having a retirement savings wake up call, which is a very important first step in preparing for the future. It’s pretty easy to save for retirement when you have access to an employer sponsored plan, but what about those who are self employed or work for a company that doesn’t offer retirement? Luckily, there are several smart and simple choices for setting up a retirement plan on your own.
Can’t I Just Save Money Without a Plan?
Of course, if you’re willing to save lots and lots of money. The beauty of having a tax deferred or tax advantaged retirement plan is the ability to save on taxes, now or in the future, plus growing money through the wonderful benefit of compound interest. Without those two things, you’ll need to save much more money to have enough for retirement after paying Uncle Sam up front and from later earnings. To see how much you’ll need to save, try out the free retirement calculator from Personal Capital.
Anyone can open a traditional IRA. If you or your spouse aren’t covered by a retirement plan at work, your entire contribution is tax deductible. If an employer sponsored plan is available to you or a spouse, funding a traditional IRA is still allowed, but your contribution may or may not be deductible, depending on income.
A Roth IRA offers no immediate tax deduction, meaning the account is funded with money that has already been taxed. However, once money is put into a Roth IRA, there is no tax on interest or withdrawals after age 59 and a half. Roth IRA’s are great for those in a low income tax bracket who feel tax rates may be higher in the future.
Workers with income under $116,00 for singles or $183,00 for married couples can contribute the full amount to a Roth. Partial contributions can be made with incomes of $131,000 for individuals and $193,000 for those who are married filing jointly. For high earners, there is still the possibility of doing a “backdoor Roth,” but make sure to check with a tax advisor if you aren’t sure about the qualifications.
How Do I Set Up an IRA?
Just about any brokerage offers both types of IRAs. Once you decide which works better for your needs, all you have to do it spend a few minutes setting up an account online. Experts recommend looking for funds with fees under 1%. Vanguard is always rated top notch and has numerous, low cost funds to choose from.
If you really want to make it easy, consider using a brokerage like Betterment that chooses investments and rebalances for you based on goals and risk tolerance.
For both types of IRAs:
- You must have earned income from wages, tips, salaries, net income from self employment, or long term disability benefits received prior to minimum retirement age. The exception is for couples who are married filing jointly when one spouse does not have earned income. A spousal IRA can be set up which allows the non-working spouse to contribute fully, even with low or no earned income.
- Contribution limits for 2015 and 2016 are $5,500 with a $1,000 catch up contribution for those over age 50. You have until April 15th of the following year to fund this year’s IRA.
- Money withdrawn before age 59.5 are subject to a 10% penalty and income tax, except under special circumstances, although Roth contributions (not earnings) can be taken out at any time without penalty.
An individual or solo 401(k) works similar to work sponsored plans but is meant for self employed people who have no employees, although a spouse who works in the business may also contribute. With this type plan, contributions can be made pre-tax or after tax if a Roth 401(k) option is chosen.
Solo 401(k) plans are great for those who want to sock away large amounts of income. Participants can make employee contributions up to $18,000 with an extra $6,000 for those over age 50. In addition, 25% of compensation, up to $53,000 (or $59,000 for those over 50) in 2015, can be invested as an employer contribution. The sum of employer and employee contributions cannot exceed 100% of compensation.
There are several brokerages who offer solo 401(k) plans. This is the type of plan I set up trough Vanguard after selling my practice, and it’s been a great way to save for my own retirement. There was some initial paperwork that had to be submitted, but after that, all the contributions can be done very easily online. There is no set up fee and the annual maintenance fee is $20, which is waived once you have $50,000 in the account.
Since then, I’ve read good things about Fidelity’s solo 401(k) plan. They allow you to roll IRA’s into your solo 401(k), which is important for high earners who wish to do a backdoor Roth without filing pro-rata forms.
You do need an EIN before setting up a solo 401(k), which is also a good idea for tax and liability issues anyway. Once your account reaches $250,000, there are extra IRS forms which must be filed.
A Simplified Employee Pension or SEP IRA is another type of tax advantaged account for those who are self employed. You can have a SEP for one person or for employees if applicable. Contributions are made by the employer. For 2015, 25 percent of compensation up to $53,000, whichever is less, can be invested.
SEP-IRAs are quicker to set up and have less paperwork than solo 401(k) plans. You don’t have to have an EIN to establish one, although you probably should have a business tax ID no matter which plan is chosen. SEP-IRAs also work great for those who do have an employer sponsored plan plus self employment income from side hustles.
However, for self employed workers without a traditional employer sponsored retirement plan, having a SEP-IRA means you won’t be able to put aside as much money as you could with a solo 401(k).
Let’s say your business makes $100,000 in net compensation this year. With a SEP-IRA, you can contribute 25% or $25,000 to retirement. Not bad, but with a solo 401(k), you could sock away this amount plus an additional $18,000 or $24,000 if over age 50. The point becomes moot if you aren’t able to contribute this much, but if you can, the solo 401(k) might be a better option, even with the extra paperwork.
Of course there are other ways to save for retirement, including HSAs, passive income investments, or non-tax advantaged accounts, but having tax advantages is nice, especially when looking at higher tax burdens of being self employed.
Do you have an employer sponsored retirement plan or are you on your own?